What Exactly is a Balance Sheet: Definitions and Benefits
A balance sheet is a statement of the financial position of a business that lists the assets, liabilities, and owner’s equity at a particular point in time. In other words, the balance sheet illustrates your business’s net worth.
The balance sheet may also have details from previous years so you can do a back-to-back comparison of two consecutive years. This data will help you track your performance and will identify ways to build up your finances and see where you need to improve.
You can also use the balance sheet to determine how to meet your financial obligations and figure out the best ways to use credit to finance your operations.
The balance sheet is the most important of the three main financial statements used to illustrate the financial health of a business. The other two are:
- The income statement, which shows net income for a specific period of time, such as a month, quarter, or year. Net income equals revenue minus expenses for the period.
- The cash flow statement, which shows the movements of cash and cash equivalents in and out of the business. Chronic negative cash flows are symptomatic of troubled businesses.
Incorporated businesses are required to include balance sheets, income statements, and cash flow statements in financial reports to shareholders and tax and regulatory authorities. Preparing balance sheets is optional for sole proprietorships and partnerships, but is useful for monitoring the health of the business.
An up-to-date and accurate balance sheet is essential for a business owner looking for additional debt or equity financing, or who wishes to sell the business and needs to determine its net worth.
All accounts in your general ledger are categorized as an asset, a liability or equity. The relationship between them is expressed in this equation:
Assets = Liabilities + Equity
The items listed on balance sheets vary from business to business depending on the industry, but in general, the balance sheet is divided into these three categories.
As in the balance sheet example shown below, assets are typically organized into liquid assets: those that are cash or can be easily converted into cash, and non-liquid assets that cannot quickly be converted to cash, such as land, buildings, and equipment.
The list of assets may also include intangible assets, which are much more difficult to value. Generally accepted accounting principles (GAAP) guidelines only allow intangible assets to be listed on a balance sheet if they are acquired assets with a lifespan and a clearly identifiable fair market value (the probable price at which a willing buyer would buy the asset from a willing seller) that can be amortized. These are reported on the balance sheet at the original cost minus depreciation. This includes items such as:
- Franchise agreements
- Copyrights
- Patents
Read Also: What is the Meaning of Business Finance
Liabilities are funds owed by the business and are broken down into current and long-term categories. Current liabilities are those due within one year and include items such as:
- Accounts payable (supplier invoices)
- Wages
- Income tax deductions
- Pension plan contributions
- Medical plan payments
- Building and equipment rents
- Customer deposits (advance payments for goods or services to be delivered)
- Utilities
- Temporary loans, lines of credit or overdrafts
- Interest
- Maturing debt
- Sales tax and/or goods and services tax charged on purchases
Long-term liabilities are any that are due after a one-year period. These may include deferred tax liabilities, any long-term debt such as interest and principal on bonds, and any pension fund liabilities.
Equity, also known as shareholders’ equity, is that which remains after subtracting the liabilities from the assets. Retained earnings are earnings retained by the corporation — that is, not paid to shareholders in the form of dividends.
Retained earnings are used to pay down debt or are otherwise reinvested in the business to take advantage of growth opportunities. While a business is in a growth phase, retained earnings are typically used to fund expansion rather than paid out as dividends to shareholders.
Example of a Balance Sheet
COMPANY NAME
BALANCE SHEET as at __________ (Date)
| ASSETS | $ | LIABILITIES | $ |
| Current Assets: | Current Liabilities: | ||
| Cash in Bank | $18,500.00 | Accounts Payable | $4,800.00 |
| Petty Cash | $500.00 | Wages Payable | $14,300.00 |
| Net Cash | $19,000.00 | Office Rent | — |
| Inventory | $25,400.00 | Utilities | $430.00 |
| Accounts Receivable | $5,300.00 | Federal Income Tax Payable | $2,600.00 |
| Prepaid Insurance | $5,500.00 | Overdrafts | — |
| Total Current Assets | $55,200.00 | Customer Deposits | $900.00 |
| Pension Payable | $720.00 | ||
| Fixed Assets: | Union Dues Payable | — | |
| Land | $150,000.00 | Medical Payable | $1,200.00 |
| Buildings | $330,000.00 | Sales Tax Payable | |
| Less Depreciation | $50,000.00 | Total Current Liabilities | $24,950.00 |
| Net Land & Buildings | $430,000.00 | ||
| Long-Term Liabilities: | |||
| Equipment | $68,000.00 | Long-Term Loans | $40,000.00 |
| Less Depreciation | $35,000.00 | Mortgage | $155,000.00 |
| Net Equipment | $33,000.00 | Total Long-Term Liabilities | $195,000.00 |
| TOTAL LIABILITIES | $219,950.00 | ||
| Owners’ Equity: | |||
| Common Stock | $120,000.00 | ||
| Owner – Draws | $50,000.00 | ||
| Retained Earnings | $128,250.00 | ||
| Total Owners’ Equity: | $298,250.00 | ||
| TOTAL ASSETS | $518,200.00 | LIABILITIES AND EQUITY | $518,200.00 |
Read Also: The Definition, Types and Importance of Finance
For a startup business, it is a good idea to have an accountant do your first balance sheet particularly if you are new to business accounting. A few hundred dollars of an accountant’s time may pay for itself by avoiding issues with the tax authorities. You may also want to go over the balance sheet with your accountant after any major changes to your business.
Balance sheets are easy to do if you use accounting software. Accounting software designed for small businesses can keep track of all your accounting information and generate balance sheets, cash flow statements, and other reports automatically as needed.
